Witches’ brew is defined as a threatening mixture or diabolical concoction. Perhaps the most iconic example is from Macbeth. The witches in Shakespeare’s story stand over their caldron and recite the famous line "Double, double toil and trouble" as they attempt to work their magic by combining a list of ominous-sounding ingredients. The incantation is meant to communicate the witches' intent to create trouble for the mortals around them.
Combining the right elements created the havoc in Shakespeare’s story, and in a similar vein, investors this week were subjected to a malevolent brew of the market’s making. Weak economic data, mixed corporate earnings, and the developing risks around Ebola pressured the market. The building body of data pointing toward global deflation is beginning to worry investors. Globally, both consumer and producer pricing levels continue to miss expectations, drawing many to deduce that excess capacity is a likely issue. The weakness in the global data has caught the FOMC’s attention as several members this week were intimating that any rate hikes were likely further out in 2015 and that additional quantitative easing was a possibility.
Risk assets had a tumultuous time, putting in yet another weak performance. Global equities finished the week 1 to 2 percent lower after having dropped in excess of 3 to 5 percent during the mid-week sell off. Investment-grade credit spreads finished the week flat while high-yield spreads widened by 10 basis points. Volatility pushed up, breeching recent highs, as the VIX had a reading of 31. For perspective, this was the highest reading since December 2011.
Global sovereign rates finished the week mixed as most tier-one sovereigns had rates fall by 5 or more basis points. The peripheral sovereigns came under pressure as investors shed risk into the equity sell off. Greek debt was the worst performer of the week as yields moved as high as 9% before rallying to 7.80%, which was 124 bps higher than last week’s close. Intraweek, German rates hit another all-time low as 10-year rates hit 0.74% before closing on Friday at 0.85%- 3.6 basis lower week-over-week.
The spread between Bunds and Treasuries narrowed by 7 basis points and finished the week at 135 basis points. Over the last four weeks the basis differential has dropped by 23 basis points. Historically, looking at the last 20 years, the average differential between U.S. and German 10-year rates is 22 basis points, so the relationship clearly has room to narrow.
Volatility this week was truly impressive, with many markets experiencing moves that were in excess of 5 standard deviations. The intra-week range on 10-year Treasury rates was a staggering 42 basis points, with a high of 2.28% vs. a low of 1.86%.
So what caused this move? Adding to the malevolent brew of Ebola, equity weakness, and a lack of liquidity was the large short base in futures. According to the CFTC, speculative short positions in 10-year Treasury futures were at the highest levels since 2007. Once the rally started the short sellers were forced to cover, which added the final element to create the extreme volatility.
In looking at the U.S. yield curve, the belly was once again the best performer of the week. The 5-year Treasury rate fell by 12 basis points as trading pushed levels to 1.11% before pulling back to 1.41% on Friday. Out the curve, the 10-year hit a low of 1.86%, a level last seen in June 2013. By mid-day on Friday 10-year rates had pushed back to 2.20% as investors’ fears were assuaged by comments from Bullard, president of the Federal Reserve Bank of St. Louis. The long bond finished the week 5 basis points lower at 2.96% after having gone as low as 2.67% during trading on Tuesday.
Last week I had noted that the increasing levels of volatility argued for maintaining a long bias, which proved correct as rates moved lower this week. Investors are in the process of acclimating to this week’s volatility and will likely look to create equilibrium with trading ranges that are 10 basis points on either side of Friday’s closing levels. Technically, the 30-year is extremely oversold and we are likely to see trading push into the 3.05% to 3.10% range. Most real money accounts appear to be duration neutral versus their benchmarks and will likely keep this posture until the volatility dissipates.
The curve finished Friday with mixed results as the front of the curve flattened while the long end steepened. The spread between 2-year and 10-year Treasuries dropped by 3.3 basis points and finished the week at 182 basis points. The path of least resistance in this relationship still suggests we will see additional flattening. I would frame the range on 2s/10s at 180/205.
Last week I had written about how the market had fired a warning shot to investors, which was clearly a precursor to this week’s volatility. The sell off this week can be attributed to the uncertainty around global growth and the added element of Ebola, creating quite a toxic brew. The increasingly dovish tone from the FOMC calmed investors this week, but at some juncture the elixir of cheap money will cease to work.